The Credit Rating Agencies and Their Contribution to Financial Crisis

The Credit Rating Agencies and Their Contribution to the Financial Crisis MAURICE MULLARD
Introduction
The central concern of this article is to explore the question of whether the Credit
Rating Agencies(CRAs)contributed to
thefinancial crisis of2007.In debating
this issue there are two perspectives.The first is presented by the senior managers
of the CRAs who pointed out that all major
market participants,including the CRAs,
did not predict the depth of thefinancial
crisis and that the crisis was an exogenous
event.The alternative view tends to put
the emphasis on institutional failures,in-
cluding deficiencies in the mathematical models used by the CRAs,the conflict of interests inherent in the user pays model and the quasi monopoly positions of the CRAs.1Evidence produced in testimonies by analysts and Moody’s and Standard& Poor’s(S&P)tended to put the focus on market share that undermined the ethics of independent impartial analysis.
In the following sections it shall be
argued that the study of the ratings pro-
cess confirms the view that the priority of
the management teams at the CRAs was
to maintain market share and to issue a
rating for a bond,even when their ana-
lysts expressed concern about the sound-
ness of the securities was a contributory factor in thefinancial meltdown.
There have been a number of factors
outlined at different enquiries2to try and explain how the CRAs failed to forecast major downgrades in such a short space time of time when it was the taken-for-granted assumption that triple-A ratings had a minimum life expectancy of seven years.3These explanations included:.The CRA‘business issuer pays’model which altered the priorities of the CRAs as they became more focused on gen-erating fees and higher profits.
.The issue of conflict of interest between the commitment of the impartial agency and issuer fees that under-mined the ethics of the research-based analysis and the managerialism of the CRAs.
.The failure of the mathematical mod-els,mainly because the data did not reflect the new mortgages and relied on classic thirty-year traditional mort-gages.The new adjustable rate mort-gages,teaser mortgages and non-documented mortgages were qual-itatively different from traditional mortgages.Furthermore,there was reluctance on the part of the CRAs to deploy revised mathematical models. .Evidence given by analysts at a number of enquiries showed the reluctance of some of them to rate some issues as they were ignored,marginalised and in some cases made redundant by their management teams.
.Despite the heavy workloads,the CRAs were understaffed and the new staffbeing recruited did not have suffi-cient expertise to deal with the need for due diligence in dealing with issuers of asset-backed bonds.
.The legal framework did not provide a context for CRAs to be taken to court for lack of diligence and for error in the ratings of bonds.CRAs were therefore exempt from legal accountability for their performance.
#The Author2012.The Political Quarterly#The Political Quarterly Publishing Co.Ltd.2012
Published by Blackwell Publishing Ltd,9600Garsington Road,Oxford OX42DQ,UK and350Main Street,Malden,MA02148,USA77 The Political Quarterly,Vol.83,No.1,January–March2012
The Securities and Exchange Commis-
sion report of September2008starts with
the following remark:
Beginning in2007,delinquency and foreclo-sure rates for subprime mortgage loans in the United States dramatically increased,creating turmoil in the markets for residential mort-gage-backed securities backed by such loans. ...The rating agencies performance in rating these structuredfinance products raised ques-tions about the accuracy of their credit ratings generally as well as the integrity of the ratings process as a whole.4
The report concluded that while the
workloads of the CRAs on the new
asset-backed securities increased,espe-
cially on the collateralisation of collater-
alised debt obligations(CDOs),the rating
agencies were not employing sufficient expert staffto deal with the new
demands.Furthermore,despite the anxi-
ety of some analysts in the rating process,
the asset-backed securities were still
rated as triple-A.Finally,the report
pointed to the lack of transparency in
the ratings decisions,the use of risk mod-
els and adjustment to these models that was not always transparent.
[T]he rating agencies examined did not always fully document certain significant steps in their subprime RMBS[residential mortgage-backed securities]and CDO ratings process.This made it difficult or impossible for Commission examiners to assess compli-ance with their established policies and pro-cedures,and to identify the factors that were considered in developing a particular rating.5 Warren Buffett,Chief Executive Officer (CEO)of Berkshire Hathaway,and Ray-mond McDaniel,CEO at Moody’s,in their evidence to the Financial Crisis Inquiry Commission(FCIC)hearings on 2June2010,both pointed out that no one could have forecasted the sharp decline in house prices during2007.6The sharp reductions reflected a major exogenous event that was not predicted.Warren Buffett described the continuing increases in house price after2000as being a form of narcotic for the majority
of people in America.Low interest pay-
ments and continuing increases in house
prices encouraged families either to trade
and move into larger homes,taking on
larger mortgages or using their homes as collateral to borrow monies from banks
and improve household consumption.
Senior managers of the CRAs,in their
submission of testimonies and evidence
at various Senate,House of Representa-
tives and FCIC hearings,tended to argue
the case that their decision to downgrade
to below investment grade of US$4tril-lion of asset-backed securities that they had previously rated as triple-A did not represent a failure of the ratings agencies, but rather reflected the wider context of market forces.No market participant was able to predict the depth of the crisis.The ratings agencies were modelling their ratings on the history of the assets that formed a mortgage-backed security.Ray-mond McDaniel explained the deteriora-tion of the asset-backed securities as follows:
With respect to CRAs,some market observers have expressed concerns that credit ratings did not better predict the deteriorating condi-tions in the US subprime mortgage market and the impact on the credit quality of resi-dential mortgage-backed securities(‘RMBS’). ...Moody’s is certainly not satisfied with the performance of our ratings during the unpre-cedented market downturn of the past two years.We,like many others,did not anticipate the unprecedented confluence of forces that drove the unusually poor performance of subprime mortgages in the past several years.7
As far as McDaniel was concerned,there-
fore,the failure to predict the fragility of
the housing market was not just confined
to the CRAs,but other market partici-
pants had equally not been able to predict
thefinancial crisis.Market forces pre-vailed and implicitly,therefore,the CRAs could not be blamed.
The CRAs’connection to thefinancial
crisis was related to their failure in acting
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as gatekeepers when it came to the rat-
ings of the asset-backed securities for
mortgages,car loans and card credit
loans.The highly coveted triple-A ratings
undersigned by the two major CRAs—
Moody’s and Standard&Poor’s(S&P)—were undermined when,within a period
of eighteen months,bonds that had been
rated as triple-A were downgraded by
the same CRAs to below investment
grade.After2005,the CRAs were
described as being in factory mode
when it came to the ratings of asset-
backed securities including residential mortgage-backed securities(RMBS)and collateralised debt obligations(CDOs). The FCIC estimated that Moody’s and S&P rated some10,000securities as tri-ple-A between2005and2007and that Moody’s had rated US$4.7trillion in RMBS and over US$400billion in CDOs.8During the same period,the incomes for the CRAs grew from US$3 billion to US$6billion,with the CEOs earning incomes similar to their counter-parts on Wall Street.Some90per cent of these triple-A securities were down-graded after July2007to below invest-ment grade.These major downgrades contributed directly to thefinancial melt-down since banks and regulated inves-tors were now holding securities below investment grade,which meant that they had to write down losses on these assets. The ratings process and the downgrading of these securities were therefore defined as being a major failure of the ratings agencies.
Most subprime and Alt-A mortgages were held in residential mortgage-backed securities (RMBS),most of which were rated investment grade by one or more CRA.Furthermore, collateralized debt obligations(CDOs),many of which held RMBS,were also rated by the CRAs.Between2000and2007,Moody’s rated $4.7trillion in RMBS and$736billion in CDOs.The sharp rise in mortgage defaults that began in2006ultimately led to the mass downgrading of RMBS and CDOs,many of which suffered principal impairments.Losses to investors and writedowns on these secu-rities played a key role in the resultingfinan-cial crisis.9
Chairman Levin of the Senate Sub-committee for Investigations,in his open-ing address on the hearings on the CRAs, identified the issue of‘conflict of interest’as being the factor that connected the CRAs to thefinancial crisis:
Those toxic mortgages were scooped up by Wall Streetfirms that bottled them in complex financial instruments,and turned to the credit rating agencies to get a label declaring them to be safe,low-risk,investment grade securities. For a hundred years,Main Street investors trusted US credit rating agencies to guide them toward safe investments....But now, that trust has been broken....At the same time,the credit rating agencies were oper-ating with an inherent conflict of interest, because the revenues they pocketed came from the companies whose securities they rated.10
Senator Coburn,Vice Chairman to the same Senate Sub-committee for Investi-gation,in his opening remarks to the same hearings on23April2010,made the case that because the three ratings agencies had,by their designation as NRSRO(Nationally Recognised Securi-ties Ratings Organisations),obtained a monopoly position in the ratings process, they had abused their monopoly position. Moody’s and S&P were responsible for94 per cent of ratings.11Furthermore,inves-tors perceived the ratings given by the CRAs as having the seal of government approval.Investors relied on the ratings agencies despite the CRAs’disclaimers on due diligence and the ratings.The Vice Chairman then went on to suggest that the CRAs ought to lose their NRSRO status and the area of ratings opened to competition:
The NRSRO designation had become for many investors a‘government seal of approval’.The ratings they assign have received the tacit blessing of the government. ...By requiring investors to purchase only AAA assets,it created an incentive for ratings
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to be high,though not necessarily accurate.If we are ever going tofix these problems we are going to need to start by ending the regulatory use of ratings.Second,we need to tear down the NRSRO designation and open up ratings to competition where reputation is more im-portant than being in a government-approved club.12
Partnoy’s major concern was the issue of conflict of interest associated with the ‘issuer pays’business model that the CRAs created after1974.The CRAs had become the‘gate opener’for the issuer of the securitised bonds rather than the gatekeeper.The CRAs’major focus became the ratings of structured products since these generated new revenues to the CRA.
[C]redit rating agencies continue to face con-flicts of interest that are potentially more serious than those of other gatekeepers:they continue to be paid directly by issuers,they give unsolicited ratings that at least poten-tially pressure issuers to pay them fees,and they market ancillary consulting services related to ratings.Credit rating agencies increasingly focus on structuredfinance and new complex debt products,particularly credit derivatives,which now generate a sub-stantial share of credit rating agencies’reven-ues and profits.With respect to these new instruments,the agencies have become more like‘gate openers’than gatekeepers;in par-ticular,their rating methodologies for col-lateralized debt obligations(CDOs)have created and sustained that multi-trillion dol-lar market.13
Mr Eric Kolchinsky,who was employed as a CDO analyst and was later dismissed by Moody’s,in giving evi-dence to the FCIC hearing on23April pointed to the unequal relationship between the issuers of the asset backed securities who were mainly the invest-ment banks and the CRA.Kolchinsky argued that the issuer could mislead the CRA about the contents of a pooled asset and that there were no penalties for issuers who lied to the CRA.Further-more,because of pressure of market share,which had become the prevailing
mood with the CRA,it made it difficult
for the analyst to walk away from a deal: For practical purposes,we would not walk away from a deal.We couldn’t say no,so that would be the most obvious penalty,that you do in any normal business,So once that avenue is closed offbecause you want to increase market share,there’s no penalty. We were in the position of being a quasi regulator,which means we had no power to compel people to give us information.We had no power to check the veracity of their state-ments.So that,without the—without the abil-ity to say no to a deal,without the ability to compel,you just were left in this sort of limbo where you tried very hard,and many people tried very hard to force the information out. But at the end of the day,with push comes to shove,people could lie to you without a penalty.14
The credit rating agencies and the changing economic context In the mid-1970s the CRAs had started to
charge fees and moved from subscriber
fees to an‘issuer pay’model.In making
this change,the CRAs argued the case
that the‘issuer pay’model did not repre-sent a conflict of interest since individual
issuers tended to be small,generating
about1per cent of CRA revenues,so
that losing an issuer to a competitor was
a non-issue.15However Macey(2003)was able to point out that this argument was only relevant as long as the CRAs were rating corporate bonds.16However,that context changed after2000when the CRAs’main business became the ratings of mortgage-backed securities and CDOs and where the market was now dom-inated by twelve underwriters that ac-counted for80per cent of the deals and when losing a deal became a major con-cern.Moody’s could not afford to lose a rating to another competitor like S&P or Fitch.Each rating agency was determined to maintain market share.Loss of market share signified failure and loss of confid-
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ence on the part of the issuers.This
created a climate where the concern was
market share and where analysts had to
explain their reluctance to agree on a
rating;if analysts proved to be difficult
they were removed:
The failure of the rating agencies can be seen as an example of regulatory capture,a term used by economists to describe a scenario where a regulator acts in the benefit of the regulated instead of the public interest....In this case,the quasi regulators were the rating agencies,the regulated included banks and broker/dealers,and the public interest lay in the guarantee which taxpayers provide for the financial system.17
This concentration of issuers had
shifted the balance of power to the issuers
who could now argue they could always
go to a competing rating agency to get a
rating if the rating agency was proving to be difficult.In this new climate,rating
agencies found it difficult to walk away
from a deal:
I’ll start with an analogy to describe the market players.Picture the organizations in thefinancial markets as animals roaming an open plain.The hedge funds were wolves, hunting in packs,eating what they killed.The investment banks were a now extinct species of predatory cats,saber-toothed tigers,larger and more powerful than the hedge funds.The money center banks were the elephants,big, indestructible,almost a feature of the land-scape.And the rating agencies?They were definitely the goats—specifically,the scape-goats.The analogy is almost perfect.From the perspective of the other market players,rating agencies fought over scraps to perform a necessary but lowly task....The last reason that large rating agencies like Moody’s are too popular as scapegoats is the glaring conflict of interest at the heart of their business model. They are paid by the issuers they rate.18 There were three possible mechanisms by which the CRAs influenced thefinan-cial crisis of2007.First,the rating agen-cies were facilitators of the process because of their triple-A ratings of asset-backed securities,including RMBS,the collating of CDOs made up of different
RMBS and synthetic credit default swaps
(CDS).These triple-A ratings increased
the demand for these asset-backed secu-
rities by institutional investors including
pension funds.Second,the original len-ders of mortgages could now offload their
holdings of mortgages to investment
banks that turned these mortgages into
pools of mortgage-backed securities with
the original lender now having new
funds to generate new mortgages.This
process of securitisation contributed to a
climate of disavowal of responsibility. Mortgage originators no longer had the responsibility for holding to a mortgage until it had been paid off.The investment banks that securitised these mortgages had no major concern for due diligence since their aim was to get a rating for the securities and being able to offload these to the investor.Equally,the ratings agen-cies made clear on their websites that they had no responsibility for due dili-gence and that therefore it was up to the investor to carry out due diligence in making the decision to purchase an asset-backed security.Originators of mortgages,including mortgage brokers, now had the incentive to sell high-cost mortgages to consumers since these mortgages provided them with higher income fees.Third,the triple-A rating reduced capital requirements to be held by banks,which in turn created a climate for higher leverage by banks and increased exposure to mortgage pools. Triple-A ratings meant reduced risks on assets which in turn required less capital requirements.Institutional investors,in-cluding pension funds,diverted their portfolios to mortgage-backed securities so that when the crunch came,these institutional investors were faced with heavy losses,which in turn effected pen-sion payments and municipalities that had invested in RMBS securities.Finally, the decision to revise downwards the ratings of large numbers of mortgage-backed securities and CDOs during July
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2007also contributed to undermining an already brittle market confidence.CDO sales dried up in2008and banks were left with large numbers of unsold mortgage pools.
One of the many paradoxes during the financial meltdown of2007was what seemed to be a rush by the major invest-ment banks in the securitisation of a number of mortgage-based CDOs when the signals were already clear that the housing market had peaked and house prices were starting to fall.The Zandi report had predicted,in October2006,a crash in house prices.19Furthermore, there were other reports during2007. However,immediately after the release of the Zandi report,the CDO rating jumped from US$20billion to US$40 billion.In January2007,after the issue of a second report by Moody’s,the rating again jumped from US$10billion to US$55billion.In the space of ninety days,the ratings of CDOs jumped by60 and70per cent.When the logic would have been to slow down the number of ratings,securitisations actually assumed a more rapid pace.Moody’s increased the rate of CDO ratings after October2006 from US$10billion a month to US$40 billion in April2007.In October2006, with the housing market showing thefirst signs of decline in house prices(by2per cent)and an increase in the number of defaults,Moody’s report,authored by Chief Economist Mark Zandi,warned that there would be a crash in house prices and that the decline would be in double digits:
Reinforcing the shift from housing boom to bust is the rapidly-exiting investor.Higher borrowing costs,more cautious lenders,and, most importantly,the realization that house prices were no longer headed higher have inducedflippers to stop buying,and if pos-sible,to sell.Longer-term investors are also re-evaluating their strategies.Even if they were willing to look through the likely near-term weakening in housing values,it is diffi-cult to justify such an investment as the cash or income return on housing has fallen shar-ply in recent years.20
In2007thefive investment banks
seemed to be in a hurry to shift a number
of loans that they still held on their
balance sheet to securitised CDOs.
Issuers were putting increased pressure
on the CRAs to conclude ratings in
shorter time spans,despite the fact that the ratings agencies did not have the
additional staffrequired to meet the extra
demands and were therefore becoming
more dependent on the hiring of less
experienced analysts.A series of emails
from within S&P,published as exhibits at
the enquiry on23April2010,reinforced
the concerns of the analysts on staffshortages:
From Ernestine Warner Director of Finance Surveillance writing about her concerns on staffshortages and the pressure on ratings of RMBS.[There were something like5,900 transactions and the Director was losing key members of staffbecause of promotions]: Unfortunately,the timing could not be worse. RMBS has an all time high of5900transac-tions.Each time I consider what my group is faced with,I become more and more anxious. The situation with Lal,being offline or out of the group,is having a huge impact.Ernestine Warren
Sent:Friday,April28,20062:11PM To:Chun, Roy Subject:RE:Discussion with Lal Ernes-tine Warner,Director,Standard and Poor’s Structured Finance Surveillance
In addition to the project above that involves some863deals,I have a back log of deals that are out of date with regard to ratings.When Steve and Kristie join the group as research assistants,they will take on the responsibil-ities of Jessica Rivera and some from Ash Rao so that Jessica can review the deals full time and Ash can review them maybe50%of the time.This will help cover the void Lal left when he became the business analyst for the initiative,but again,does not move us any closer to FTS in the short term.We recognize that I am still understaffed with these two additional l being offline clearly exacerbates this problem and we may be fall-ing further behind at the rate the deals are
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closing.If we do no not agree on the actual number,certainly we can agree that I need more recourse if I am ever going to be near compliance.
Sent:Thursday,June01,200611:46AM To: Chun,Roy Coyne,Patrick.21
The securitisation process
The process of securitisation has been
described as a majorfinancial innovation that has contributed to faster economic
growth.Major industries were increas-
ingly using derivatives tofinance their
borrowings and since over-the-counter
(OTC)derivatives were highly custo-
mised,large companies were resorting
to derivatives,which was also a cheaper
way to fund investment:
For instance,a recent study that examines the use of derivatives by non-financialfirms in-vestigates6,888firms from47countries dur-ing2000and2001.Thesefirms constitute99% of the world market capitalization.Itfinds that60.5%of thesefirms use derivatives. The sample includes2,076U.S.firms and 65.1%of thesefirms use derivatives.The study concludes that using derivatives makes firms less risky and worth more.In2009, ISDA conducted a survey of derivatives usage by the world’s largest corporations,those corporations in the Fortune Global500.The surveyfinds that94%of the world’s largest corporations use derivatives.22 Derivatives had also facilitated home ownership as the process of securitisation allowed for grater lending,spreading risk and thus making mortgage loans cheaper and so increasing efficiency infinancial markets in the allocation of savings and easing the use of collateral such as hous-ing to increase household consumption.23 It is estimated that securitisation has funded30–75per cent of lending in vari-ous markets,including an estimated59 per cent of outstanding home mortgages. Furthermore,securitisation played a cri-tical role in non-mortgage consumer credit,including credit card purchases, and in the car industry where a substan-tial portion of sales were beingfinanced
through asset-backed securities.The
CDO asset-backed securities collated
pools of mortgages,credit card debt and
auto sales.Securitisation had become a
means of facilitating over25per cent of outstanding American consumer credit:
Housing assets as a class were worth
approximately US$22trillion within a
context of total household wealth of
US$65trillion.There were over US$12
trillion of outstanding securitised assets,
including mortgage-backed securities,
asset-backed securities and asset-backed commercial paper.
The securitisation of mortgages repre-
sented a shift from the traditional‘origin-
ate and hold’mortgage process to an
‘originate and distribute’model.The‘ori-
ginate and hold’model meant that banks
had to carry out due diligence in the
lending of money to mortgage applicants since the lender would hold the mortgage until the mortgage had been repaid.Care-ful documentation on employment,sal-aries and income tax returns ensured that mortgage holders were able to meet their monthly payments.By contrast,the‘ori-ginate and distribute’model created by securitisation meant that there was little downside for those originating the mort-gages since their main concern was the making of fee income,being paid the fee being paid immediately when the trans-action was completed,and then moving the mortgages to brokers for securitisa-tion,who in return were also paid fess for collating mortgage pools.
The process of pooling loans and turn-
ing these into investment bonds facili-
tated the easy movement of savings into
consumer demand.It is estimated that
during the peak of the securitisation pro-
cess about US$3trillion a year were being
securitised.Due to the process of secur-
itisation,banks and mortgage brokers were able to sell mortgages they held to investors,thus realising new forms and additional income to offer new mort-gages.Furthermore,a climate of low
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interest rates,which started in2000,
meant cheaper loans.Savings arriving
from China and other emerging econo-
mies meant a high demand for United
States Treasury bonds,which in turn
continued to provide a low interest rate environment.Banks were now awash
with savings and investors seeking
higher yields.Securitisation of thousands
of mortgages into bonds provided stable
repayments for a long period.The pay-
ment of principal and interest rate pay-
ments could be sold,providing steady
incomes for investors.Investment banks holding large pools of mortgages now securitised the pools as asset-backed bonds.Within a pool containing about one million mortgages,issuers of poten-tial bonds rated the mortgage pool in terms of default.One million mortgages were less likely to default than one hun-dred mortgages,and since the mortgage would contain a representative sample from all regions,the assumption was that there would be low correlations within a mortgage pool.Detailed analysis of each mortgage entry in terms of documentation—for example,pay slips, income tax returns,evidence of employ-ment—was left to the mortgage origina-tors.
Analysts at both Moody’s and S&P
used various models to forecast the levels
of default within a mortgage-backed
security.The rating agencies in process-
ing the forecast were not responsible for
due diligence in the content with an
RMBS.Their duty was not to analyse individual entries to explore documenta-tion or mortgage testing.These were assumed as being correct.Modelling was done using traditional thirty-year mortgages that had little history of default.Mortgage-backed securities were made up of pooled mortgages.An arranger or issuer of a mortgage-backed security bond would seek to pool about a thousand mortgages worth an equivalent of US$1billion.The mortgage repay-ments defined the worth of the bond.The bond would be diced and sold in
tranches with senior tranches being the
safest and making thefirst claims on the
repayments,and mezzanine tranches
receiving higher rates of interest but
also facing higher risk of default.
The development of collateralised debt obligations Ratings of CDOs increased from US$10
billion a month in2004to US$40billion a
month in2007,despite a number of early
warnings in2006that the housing market was already peaking and showing signs
of stress.CDOs were made up of already
securitised mortgage-backed securities
and asset-backed securities.Within a
CDO,therefore,there were already a
number of rated bonds.However,since
a CDO could be worth billions of dollars,
there would be millions of individual mortgage entries,car loans,credit card and student loans all pooled within the CDO.Rating a CDO was complex.How-ever,during the peaks in the numbers of CDO transactions,analysts were expected to take only a couple of weeks to rate a CDO.
Synthetic CDOs and CDOs squared were one step removed from mortgage-based securities.Synthetic CDOs were often made up of a number of indices like the Asset-backed Securities(ABX) index and also included CDS(credit default swaps)on respective CDOs.A CDS sought to imitate a CDO that con-tained mortgage-backed securities.The CDS was actually a forecast that certain CDOs were likely to default.The arranger and investor in the synthetic CDO had to tailor and customise it to the needs of the buyer and the seller,with the investment bank usually acting as the market maker.
A prime example was the ABACUS CDO
that was arranged between Goldman Sachs and John Paulson,who selected the CDOs to be included in the synthetic CDO before the CDO was rated by Moody’s.Hedge funds that wanted to
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